SIA Engineering - CGS-CIMB Research 2018-07-31: Cash Rich, Long-term Event-driven Stock

SIA Engineering - CGS-CIMB Research 2018-07-31: Cash Rich, Long-term Event-driven Stock SIA ENGINEERING CO LTD SGX:S59

SIA Engineering - Cash Rich, Long-term Event-driven Stock

  • SIAEC’s valuation is more palatable at 18x CY19F P/E, -1 s.d. of its 7-year mean (23x).
  • We lift FY19-20F EPS by 19-20% to factor in higher contributions from JV/associates as problematic Trent 1000 Rolls Royce engines continue to drive engine repair.
  • SIAEC is cash rich with net cash of c.S$500m (S$0.44/share); this should sustain a DPS of S$0.13-0.14, translating into a dividend yield of 4-5%.
  • With our EPS upgrade, our Target Price is raised to S$3.31, still based on DCF. At our target price, the stock would be trading at 21x CY19F P/E or -0.5 s.d. from mean.

Valuation more palatable at -1 s.d. of 7-year mean; limited downside

  • We think the 22% decline in share price over the past 12 months has been due to SIAEC’s exclusion from the STI index since Aug 17 amid structural challenges in airframe MRO. Now at 18x CY19F P/E, however, below its 7-year mean of 23x, SIAEC is more palatable. We also note that the valuation gap between SIAEC and STE narrowed to 0% from an average of 30% in the past 3 years.
  • We believe EPS growth of 6% could limit downside.

~ ~ Where SG investors share

Rolls Royce’s poison could be SIAEC’s meat

  • JV and associates’ earnings have grown two consecutive years with momentum continuing into 1Q19 to S$32m (+54% y-o-y) or 80% of SIAEC’s PBT, largely on rectification work for Rolls Royce (RR)’s Trent 1000 engines that have been suffering corrosion at a faster rate than expected since end-16. 
  • RR has heightened global MRO capacity and expects to spend £300m over 2018-19 to fix the problem. This could have a positive spillover on SIAEC’s RR JV, SAESL, with more engine inspections if there is no shortage of spare parts.

Pratt & Whitney’s sunset and sunrise engines

  • Pratt & Whitney (PW) associate, Eagle Services (ES), has had a good 2 years benefiting from airlines extending the use of older B747s on the lower oil price trend. Accordingly, associate profits delivered a 3-year CAGR of 15%. With rising oil prices, airlines are starting to retire the gas-guzzling classic B747s more quickly and replacing them with twin-engine B787s.
  • We could start to see earnings growth taper off from FY20F but earnings downside could be cushioned by the GP7200 engines that power 60% of the A380 fleet, which are due for checks as it has been 10 years since they entered service.

Valuation Call

  • Our previous grouse regarding SIAEC was its expensive valuation at above 20x forward P/E vs. the tepid earnings growth. However, we think the removal of SIAEC from the STI index since Aug 17 has led to 12M share price underperformance. Besides, illiquidity with free float of c.20% also steered away institutional interest. Since then, valuations have turned more palatable to 18x CY19F P/E and c.-1 s.d. from its 7-year mean.
  • We also note that the valuation gap between SIAEC and STE has narrowed to 0% from an average of 30% in the past three years. The EPS growth in FY19F and DPS of c.S$0.13-0.14 could limit share price downside, in our view.

We were too bearish with JV and associates

JV profit lifted by Trent engine problems

  • Contribution from JV and associates in FY18 of S$110m beat our forecast by 14% while 1Q19’s contribution of S$32m was 25% above our expectations, making up 60% and 80%, respectively, of SIAEC’s profit. This stemmed mainly from more rectification work for RR’s Trent 1000 engines in SIAEC’s only JV, SAESL, as profit contribution grew 142% y-o-y to S$8.4m in 1Q19.
  • The Trent 1000 engine failure (mainly used to power the Boeing 787 Dreamliner) started to surface in 2016 with All Nippon Airlines (ANA). Engine failures were said to have been caused by corrosion and cracking of turbine blades. That resulted in ANA replacing 100 Trent 1000 engines over a three-year period. Other airlines, such as Air New Zealand, have also reported similar problems with their Trent 1000 engines. RR has about 500 Trent 1000 engines in service, which have been hit by similar issues. RR is in the process of replacing blades in the turbines, which have not lasted as long as expected. Given the heightened measures taken to expand repair capacity, RR has announced it is spending £300m over 2018-19 to fix the problems. This could have a positive spillover to SIAEC’s RR JV, SAESL, with more engine inspections, if there is no shortage of spare parts.

Associates’ sunset and sunrise engines

  • Associate profit was largely contributed by Eagle Services’s increased workshop visits for the perceived sunset Pratt & Whitney PW4000 engines in a low oil price environment in the past two years. Accordingly, associate profits delivered a 3- year CAGR of 15%. PW4000 are mainly used to power the classic B747 aircraft. Judging from the latest 1Q19 performance, associates’ work load appeared to remain strong but this could be lumpy. Management has conservatively warned in the previous analyst briefings that the strength may not sustain. We also noted SIAEC’s share of Eagle Services’s profit growth started to taper in FY18. Against a backdrop of rising oil prices, airlines could start to retire the gas-guzzling classic B747s more quickly, to be replaced by twin-engine B787s.
  • However, there could be a glimmer of hope in the GP7200 engines as Eagle Services was made the 4th engine overhaul centre (and the first in the Asia-Pacific region) for Pratt & Whitney’s GP7200 engines that are used to power the A380 aircraft. The GP7200 engines power 60% of the global A380 fleet. The first GP7200 engines entered service with Emirates in 2008. Other airlines’ A380s that are powered by GP2700 include Air France, Etihad Airways, Korean Air and Qatar Airways. We believe Eagle Services could get a share of the work, together with Pratt & Whitney’s other MRO centre, Emirates Engine Maintenance Centre.

SIAEC’s core airframe MRO would still lose out to OEMs but SIA volume and line maintenance could still provide baseload

  • OEM encroaching into the third-party MRO space is one trend that SIAEC cannot defy. Non-OEM MRO players like SIAEC could be an integral part of the OEM controlled network in order to get some share of the work. However, in general, the service depth and the ability to provide work to third-party MRO players are increasingly restricted, especially by the growing intellectual property protection and data sharing/analytics on repair plans.
  • SIA still dominates about 60% of SIAEC’s revenue. We think 2H19F revenue would be helped by the cabin retrofitting work on SIA’s A380 fleet that should come in by end-18. Line maintenance continues to contribute 40-50% of the group’s revenue. With more work being transferred from apron to hangar, SIAEC now consolidates the disclosure of revenue between airframe and line maintenance. Based on the number of flights handled at Changi (average growth of c.2% since 2016), we can safely assume that line maintenance work is sustained, with upside coming from increased A checks.

Positive jaws in staff costs vs. revenue, with more work in Clark, Philippines

  • SIAEC has managed to reduce staff costs p.a. by a greater quantum compared to the revenue decline since 2015 despite the gradual increase in headcount. Other than increasing productivity via investments in data analytics/digitisation to enhance productivity, we believe SIAEC has managed to control the overall costs by shifting more maintenance work, especially C checks, to its subsidiary in Clark, Philippines. Clark currently operates two narrow-body and one wide-body hangars. The number of C checks performed doubled to 56 in FY18 vs. 29 in FY14.

It costs less than one A350 for SIA to privatise SIAEC

  • Over the longer term, we believe SIAEC is an event-driven stock, awaiting privatisation by SIA. We find very little reason for SIAEC to remain listed. The company has also established itself as a choice engine MRO given the long- term tie-ups with Rolls Royce and Pratt Whitney, which make no difference whether or not it is a subsidiary of SIA, in our view.
  • We think SIA is unlikely to divest SIAEC as it remains a wingman for the airline’s new generation aircraft expansion plan. The non-SIA revenue derived at JV/associate level of c.S$2.6bn and the technical knowhow sharing from RR and PW make it harder for SIA to untangle the relationship. There is also no incentive for SIA to pare down its 80% stake in SIAEC to share the income/dividend with MI. Instead, if the valuation is right, we think SIA could consider taking SIAEC private to fully consolidate the profit and cash.
  • Assuming it is privatised at a 10% premium over the current share price, it would cost SIA c.S$750m. Backed by net cash of c.S$400m-500m, the net cost to SIA is only about S$350m.

Cheap valuation, upgrade to ADD from Reduce, Target Price up to S$3.31

  • We think SIAEC’s valuation is cheap. Secondly, earnings growth is sustained by JV and associates and line maintenance. It has also managed to reduce staff costs p.a. (bulk of costs) by a greater quantum vs. the revenue decline since 2015. Our FY19-20F net profit forecasts are raised by 22-23% on higher contributions from JV.
  • Over the longer term, we believe SIAEC is an event-driven stock, awaiting to be privatised by SIA. Stronger-than- expected EPS is a re-rating catalyst. Downside risk is a sudden slowdown in the aviation industry.

LIM Siew Khee CGS-CIMB Research | 2018-07-31
SGX Stock Analyst Report ADD Upgrade REDUCE 3.31 Up 3.130